About Me

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Physicist, Startup Founder, Blogger, Dad

Monday, September 15, 2008

Orders of magnitude and timescales

As a physicist I can't help making some comments about orders of magnitude and timescales :-)

If home prices return to normal (historical) levels, total mortgage debt losses will be about $1 trillion. This is a staggering sum, but won't destroy our economy. After all, our misadventure in Iraq will end up costing us about the same amount. [Insert anti-Bush diatribe here.] If necessary, we could socialize the whole loss like we've done with Iraq -- put it on the nation's and taxpayers' balance sheet.

The problem is that the credit bubble losses are concentrated in financial firms, which are getting hit with a huge shock as their portfolios approach the day of mark to market reckoning. This shock is going to have to be worked through the system over a relatively short timescale if we are to avoid systemic paralysis, or worse. Once a particular entity becomes insolvent, the entire web of counterparty transactions between it and the rest of Wall St. is in jeopardy.

Dealing with that relational web is the real challenge -- can we recognize the losses without impairing the functioning of our financial and banking system?

Hmmm... what we really want to do is get the money back off the people its ended up with ie. all the hedge funds and bankers with their years of enormous bonuses, all gathered when they were building financial houses for us that had no foundations (forgive me for being a little free and easy with the facts!). Of course getting it back from the sovereign wealth funds is less easy (or justified).

I know a guy who works for a civil engineering company - when they construct buildings the partners have to personally guarantee the work, such that even if they leave they have personal liability for faults up to 20 years later! I bet the guys on Wall street would have been a lot more prudent if they had to sign that kind of contract...

On the subject of sovereign wealth funds - I can't understand why the Chinese and Middle East governments think its a good idea to lend America money to buy their products, and also not buy American products of whatever form in return. Surely its obvious that in the end it blows up? Maybe its to develop their industries such that when it does eventually dry up they are better able to trade with other partners, or internally. Perhaps I am conflating too many issues (I've never understood economics that well :) ).

And back to the banks - personally I think its good if a few of them get smashed up. Although I do think the government should protect depositors and other un-sophisticated investors - primarily because the regulatory framework does not exist to inform those people about the kind of risks banks were taking with their money; which is the governments fault IMHO. In my mental model, the function of financial institutions in society should be to efficiently allocate capital, and it seems intuitively obvious to me that what has actually been happening for a large number of years now is a kind of legalised theft from "average" people so that the profits from banks are just derived from reapportioning the pie rather than making the pie bigger. Its obviously unstable this way and the disintegration is what is playing out now. So a shrinking in the financial sector is no bad thing, and coupled with better regulation we may emerge in better shape for it. Now I feel like I'm waffling obvious truisms so I'll shut up!

I know little, but here is what I understood. I thought that one of the major problems was that the debt of the investment banks were MUCH larger (like a factor of 10 or more) than the value (when it was healthy) due to derivatives. So when Lehmann went kaput, it was not just a $60 billion loss; they owed something like $600 billion. In many cases, due to the complexity of financial instruments, true debt value is unknown. What happens to all that debt?

My friends' eyes glass over when I try to communicate my fears and anxiety over the loss of real buying power. I keep thinking that I need to put together a slush fund so I can defend myself economically.

this is part of the reason the feds have been trying to change the timescale for the reckoning, the other reason, of course, being to make it Someone Else's Problem.inflating the cost away, in the medium term, is the simplest solution. Changes somewhat the who takes the hit.

Regarding loss of purchasing power: what intrigues me is the timescale on which the ongoing credit implosion might be overcome by the inflationary impact of the new Federal liabilities.

The big numbers associated with Fannie and Freddie are misleading because most of those mortgages are sound. In terms of order of magnitude, the socialized losses probably will remain at less than 20% of GDP (realized over several years) or something like 3-5 years of our ongoing fiscal deficits. Much cheaper than a major war, though maybe a bit more expensive than Iraq (all-in with veterans benefits etc).

So it seems to me the nearer term deflation may keep inflation at bay for a while yet.

STS: yes, I'm not worried about inflation right away, due to the weakening US and global economy. In the longer run inflation will be a problem.

But, the shorter run wild card has to do with the dollar -- will foreigners continue to buy our debt? Will the mortgage crisis undermine faith in the US as a safe haven for capital? We could have a run on the dollar even while (endogenous) inflation remains contained.

Currency adjustment is clearly an important piece of the puzzle. What triggered the reversal on dollar decline was the Fed pause. The Fed decided to stand pat today, but if it resumes easing, there could be another dollar slide.

Of course, other central bankers are likely to be under pressure to lower policy rates too. So ... yes ... the dollar is a wild card ;)

The only solution that comes readily to mind is a universal amnesty/valuation agreement. Give all the major mortgage holders a one-time-only chance to opt into an agreement to abide by valuations of a neutral third party, and begin rolling valuations of the housing market, like a modern Domesday Book. The parties indemnify each other for the valuations and lock-in at that price, and hopefully volatility drops sufficiently to unfreeze the credit deadlock.

I figured that my dollar exchange anxiety and inflation anxiety were rooted in the same thing. In order to shore up asset valuations, the Fed will drop interest rates to zero, everybody borrows, value of a dollar is diluted, inflation skyrockets. It didn't even occur to me that ex currencies would strengthen, relatively. [I think every one is hosed on this account, except maybe the Russians because they are always hosed].

I made the comment to a friend of mine that the government won't tolerate large scale asset devaluations. So, the good thing is that I won't be underwater on my mortgage [owing about $160k right now]. The bad thing is that my next house is going to cost me $700k.